6 Reasons to Buy An Annuity Over A CD

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As adverse market conditions force more investors into seeking alternatives that will provide more stability and certainty to their retirement portfolios, annuities have, once again, moved to the forefront of the investment landscape. Annuity sales topped $200 billion for the first time in 2011, and are expected to grow by double digit rates as tens of millions of Baby Boomers approach retirement. But, annuities, one of the oldest and most reliable financial instruments dating back centuries, are not without their controversy.

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6 Reasons to Buy An Annuity Over A CD

  1. 1. ANNUITIES VS CD’S “Find Out What Your Bank Does Not Want You To Know”Copyright 2012 - Annuity Think Tank – All Rights Reserved
  2. 2. 6 Reasons To Buy An Annuity Instead Of A CDIntroductionAs adverse market conditions force more investors into seeking alternatives that will provide morestability and certainty to their retirement portfolios, annuities have, once again, moved to the forefrontof the investment landscape. Annuity sales topped $200 billion for the first time in 2011, and areexpected to grow by double digit rates as tens of millions of Baby Boomers approach retirement. But,annuities, one of the oldest and most reliable financial instruments dating back centuries, are notwithout their controversy.The financial planning community has long been divided on annuities and whether their benefitsoutweigh the costs. Critics point to high fees and commissions, questionable sales practices, and theirunsuitability for older investors as the reasons why they should be avoided. Yet, according to an August2012 survey by Cerulli Associates, financial advisors reported that clients requested annuities more thanany other unsolicited product. And, 92 percent of Baby Boomers who own an annuity report a muchhigher degree of confidence in their retirement future.Any debate over the benefits of annuities inevitably invites comparisons to alternatives with similarattributes that may be less costly, or more liquid, and, generally, more suitable for one’s retirementsavings needs. Most notable among the alternatives are bank certificates of deposits (CDs) touted fortheir absence of fees, their safety (FDIC), and their relative liquidity (when purchased in shortermaturities).Anytime a question is posed as “are XYZs better than ABCs?” it invites controversy especially when itinvolves a comparison of “apples and oranges”. No one will argue against the notion that annuities, or,for that matter, any particular investment vehicle, isn’t for everybody. This presupposes that, using thesame rationale in reverse, CDs are also not for everybody. The only way the question can be answeredmeaningfully is when it’s posed in the context of any one person’s personal financial situation. Only witha good understanding of your client’s financial objective, needs, priorities and tolerance for risk, can youtruly make the comparison.As with any investment, the answer lies not in the investment itself; rather in the way and in thesituation in which it is applied. That is the only context in which annuities or CDs can be evaluated. Italso requires an understanding of how the investment actually works. While it is true that annuities aremore complex than CDs, it is through their complexity that their unique properties can provideunparalleled benefits in the form of tax savings, guaranteed returns, and guaranteed income. But, aswith CDs, annuities may not be right for everybody.This report provides an in depth look at annuities from several vantage points for a comprehensiveunderstanding of how they work and how they can compare to CDs.. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  3. 3. Reason #1 - Annuities and CDs – A Straight ComparisonAnnuities and CDs are often compared in the same light as if they were equivalent investments. Whilethey do share several attributes, such as guaranteed fixed yields, principal guarantees, and relativeliquidity, they’re separated by some significant differences, and that precludes a straight across apples-to-apples comparison. The only basis for any type of comparison between the two are product features. The comparisonchart below was constructed from the vantage point of an annuity only because it offers more featuresthat can be compared. Comparison of Annuities with Certificates of DepositFeatures Annuity CDGuaranteed fixed yield? Y YFree from principal/market risk and price fluctuations? Y YAre interest earnings free from current taxation? Y N 1Are accounts insured? Y YAre interest earnings reinvested automatically with no current income Y Ntaxation? 2Am I able to make small additional investments? Y NTax liability on Social Security income eliminated on deferred Y Naccumulation? 3 4Liquid? Y YFlexible? Y YPenalty free withdrawal? Y NFunds not reduced by commissions? Y YDoes this investment automatically avoid the expense and delay of Y Nprobate?Protected from legal and creditor claims? Y NGuaranteed lifetime income with tax advantages? Y NIncome excluded from Social Security tax calculation? Y NIs this investment free of annual fees and expenses? N Y1 Annuities values are secured by state guarantee funds2 When your Tax-Deferred Annuity is a Flexible Deferred Annuity versus a Single Premium Deferred Annuity; small additional deposits are allowed.3 Surrender penalties may apply4 Early withdrawal penalties may applySuch a comparison, while useful at a high level, barely begins to draw the stark contrast that existsbetween the two investments. The remainder of this report delves into several of the key aspects ofeach that are often used to contrast the two. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  4. 4. Reason #2 - Not all Guaranteed Fixed Yields are Created EquallyThe annuity product that draws the obvious comparison with CDs is the Multi-Year Guaranteed Annuity(MYGS). In fact, it is often referred to as a CD Annuity because it offers a guaranteed fixed yield forvarying maturities. However, the “maturity” period for a MYGS is more accurately described as thelength of the surrender period beyond which there are no more surrender penalties. So, a 5-year MYGAis likened to a 5-year CD for that reason.The second commonality is that both investments guarantee a fixed rate until maturity, or, in the case ofan annuity, the end of the surrender period. In both cases, the longer the maturity is, the higher thefixed rate. Generally, the fixed rates that are credited tend to follow in the direction of prevailing short-term interest rates. But that’s where the similarities end.Annuities have the Edge in Fixed RatesGenerally, the fixed rates insurance companies credit to annuities are higher than those that bankscredit to CDs. On average, the disparity can range between a half a point and a point and half dependingon the interest rate environment. At any given moment, the disparity between the highest fixed ratesavailable on specific MYGAs could be as wide as 2 points.Why the disparity? Some CD advocates would have you believe that the lower yield is the “premium”savers pay because CDs are safer. Annuity advocates would argue that annuities are just as safe (moreon this debate in the next section).In reality, the rate disparity has nothing to do with the safety, and everything to do with the way thefixed rate is determined.The fixed rates for CDs essentially mirror the short-term interest rates that banks earn minus a margin.A 5-year CD rate reflects the interest rate banks earn on short term loans, and a 30 day CD rate wouldmore closely follow the banks prime lending rate. When a CD is rolled over at maturity, the new fixedrate will reflect the prevailing interest rates at the time. In a volatile interest rate environment the creditrates can change quickly.With a MYGA, the premium deposits are invested by the insurer into high quality bonds and fixedincome investments with a duration to match the length of the surrender charge period. So, for a 6-yearMYGA contract, most of the money is invested in assets with yields that are fixed for 6 or more years.Based on the yields that are available, the insurer then sets the crediting rate. As interest move up anddown, the yield on the insurer’s portfolio remains fairly stable. For this reason, renewal rates onannuities will follow the changes in the market rates, but they won’t increase or decrease as much.The following chart shows the yield curve of MYGAs as of October 2012. The bars indicate the averageyield of all MYGAs for different maturities, and the top line shows the best rate available at thatparticular time. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  5. 5. Source: annuityratewatch.comNow contrast that with the average 5-year CD rate for the same period which, according to Market RateInsights, had fallen to a historic low of 0.99%, the first time it has ever dropped below 1%. Of course,this does reflect the low interest environment, however, Market Rate Insight also attributed theunprecedented decline to soft lending conditions which have forced banks to reduce their funding costs.SummarySo, not only are CD rates determined by the prevailing interest rate market, they can also be influencedby business conditions. For this reason, CD rates tend to fluctuate much more than annuity fixed rates,and there is really no floor for how low they can drop.Annuity rates are determined by investment yield with adjustments for market conditions. So, annuityrates tend to be more stable and higher than CD rates for the same time period. In addition, MYGAs doinclude a minimum rate guarantee to protect investors from severe rate declines upon renewal. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  6. 6. Reason #3 - The All Important Safety FactorFew questions have driven more debate in financial circles than the one that asks whether CDs are saferthan annuities. Of course, the responses are divided along institutional lines with bank reps on one sideand insurance agents on another, and then the financial advisors split somewhere between the two.While one side attempts to settle the debate with the mention of FDIC insurance for bank CDs as thedeciding factor, others would have us consider other factors such as structural integrity of the twodifferent types of financial institutions, the overall safeguards in place for life insurance companies, aswell as the actual performance of financial institutions during times of economic distress.The Case for Bank CDsThe argument for bank CDs as the safer instrument usually comes down to one single factor: FDICinsurance. The FDIC – Federal Deposit Insurance Corporation – is an agency born out of the massivefailure of the banking industry that led to the Great Depression. Its purpose is to reassure the publicthat the U.S. government stands solidly behind its deposits in banks that meet FDIC requirements.Ironically, the “I” in FDIC stands for Insurance, so the strength of this argument is based on the power ofan insurance company that happens to be government owned, controlled, and backed.The Limits of FDICThe insurance only covers one account, per individual, per bank. So, if an individual has on deposit morethan $250,000 with any bank, the amount in excess of $250,000 would not be covered. Conceivably, anindividual with a $1 million in savings would be fully insured as long as his deposits were spread amongfour different member banks. The FDIC also provides separate coverage for deposits made withdifferent forms of ownership. So, a person could have an individual checking account and a jointchecking account both covered for the full amount.Adequacy of FDIC ReservesThe great stress placed on the banking system as a result of the recent financial turmoil has raised newquestions over the solvency of the FDIC reserve. Currently, for every dollar of deposits, the FDIC has justover 1 cent of reserve available to cover any bank default. The failures of hundreds of banks over thelast several years has raised concerns as to whether the FDIC, which is not backed by the full faith andcredit of the government, is capable of covering the losses of major banking institutions should theyoccur within a short time frame. To give some perspective, since 2008, over 400 banks have filedbankruptcy. See the full list here - http://www.fdic.gov/bank/individual/failed/banklist.htmlThe Case for AnnuitiesAnnuities are issued by life insurance companies, and while these financial institutions have also felt thestrain of distressed economies, their overall record of solvency dwarfs that of the banking industry.During the Great Depression, as banks failed all across the map, the life insurance industry, stood as astabilizing force of the financial markets and the economy. In recent times, several life insurers havesuccumbed to insolvency, however, in no case has a policyholder or annuity owner ever lost a dime as aresult. Moreover, during the same period from 2008 to present, we have not found a single insurancecarrier that has had to announce insolvency and there are certainly no websites that had to be createdto list the failed insurance carriers… Copyright 2012 - Annuity Think Tank – All Rights Reserved
  7. 7. Legal Reserve RequirementsIn many respects, life insurers are held to higher standards and stricter requirements than banks orother financial institutions. For example, life insurers are required to maintain a legal reserve of liquidassets that will cover 90 to 95 percent of their obligations and future claims. Banks, depending on thereserve ratios set by the Federal Reserve, are only required to maintain a reserve of 3 to 10 percent.State Guaranty AssociationInsurance companies are regulated at the state level, and each state has established its own StateGuaranty Association which protects annuity deposits and life insurance cash value against insolvency.The guaranty limits vary by state ranging from $100,000 to $300,000. As with FDIC coverage, theguaranty fund only protects one policyholder per insurer. However, if a policyholder has contracts withtwo different insurers, both receive the maximum coverage.Institutional Financial IntegrityGenerally, life insurance companies must operate at a higher level of financial integrity than banks.Insurers are required by state regulators to maintain much higher reserves and capital surplus thanbanks. Insurers are also restricted to the amount and quality of investments they can make whichmostly consist of a portfolio of high quality debt securities.Finally, the life insurance industry is closely monitored by independent ratings agencies, such as A.M.Best, Standard & Poor’s, and Moody’s. They track the financial strength of the company and assignratings that reflect their outlook of an insurer’s capacity to pay all of its claims and obligations well intothe future. A life insurer with a AAA rating from Moody’s is considered to have superior financialstrength, while an insurer with a B rating may have some problems if economic conditions deteriorate inthe future. Although life insurer insolvencies are rare, consumers would be well advised to choose fromamong the three dozen companies that are rated A or better.SummaryVery few things in life are absolute, especially when it comes to the fallibility of institutions, bothgovernment and private, that offer guarantees. Can it be said that any financial instrument is absolutelysafe? Not with any honest measure of certainty. The best one can do in determining the degree ofsafety of any financial instrument is to consider all of the factors and all of the safeguards that are inplace.Reason #4 - Taxable CDs versus Tax-Deferred AnnuitiesWith the issue of taxation, there really is no direct comparison between CDs and annuities. The earningson CDs are taxable as ordinary income, and the earnings on annuities are not currently taxed. The realissue is how important tax advantages are to any one individual. Although tax advantages are among Copyright 2012 - Annuity Think Tank – All Rights Reserved
  8. 8. the primary reasons why people buy annuities, only those in the higher tax brackets will realize anysignificant benefits of tax deferral. On that basis, the only significant comparison to be made is how anannuity with tax deferral performs over time versus a taxable CD for any one individual.The Magic of Triple-Compounding InterestTax deferral actually produces a triple-compounding effect, which can have a significant impact on thegrowth of an investment. Earnings not currently taxed increases the amount of money that is reinvestedwhich generates increased earnings that continue to grow tax deferred, and that will always generate afaster rate of growth than earnings that are taxed before reinvestment. The only issue is how muchfaster, and the primary determinant of that is the individual’s tax bracket.For example, if an individual in the 38% tax bracket invests $25,000 in a tax-deferred investment at arate of 4%, it will grow to $66,646 after 25 years. Assuming a 25% tax bracket in retirement, theinvestment would be worth $56,234 after taxes as compared to a taxable equivalent that would grow to$46,123. The more than $10,000 margin is significant.Applying the same factors for an individual is in the 25% tax bracket, the tax deferred investment wouldstill grow to $66,646 resulting in $60, 399 after tax versus $52,344 in a taxable investment - still asignificant margin but, smaller. The margin would decrease for individuals in lower tax brackets.Both of these examples assume that the individual will be in a lower tax bracket at the time ofwithdrawal in retirement and they presume there won’t be any early withdrawal penalties. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  9. 9. Tax Advantages for RetireesThe tax advantages of annuities don’t end at retirement. Not only do the earnings inside annuitiescontinue to grow tax deferred, but they are also excluded from the insidious Social Security taxcalculation.Since 1984, earned income, certain unearned income and a one-half of Social Security benefits havebeen included in a provisional income formula to determine how much of your Social Security incomewill be subject to taxes. Here’s the actual formula: 1. One-half of Social Security income 2. Plus adjusted gross income (including employment earnings, capital gains, dividends, interest earnings, pension income and annuity withdrawals) 3. Plus tax-exempt bond interestIf the total exceeds a certain threshold, a portion of Social Security income, up to 85%, will be subject totaxes. Filing status Security formula result % of Social subject to taxation Single $25,000 to $34,000 50% Single Over $34,000 85% Joint $32,000 to $44,000 50% Joint Over $44,000 85%This means that any interest earned from taxable and tax-exempt vehicles, regardless of whether it isreceived or reinvested, is includable in the provisional income formula. However, earnings reinvestedinside a non-qualified deferred annuity are excluded from the formula. Retirees, who hold significantassets in taxable, interest-bearing investments such as CDs, could reduce their exposure to SocialSecurity taxation by repositioning their asset into deferred annuities.Annuity Income also Reduces Social Security TaxSection V more fully explores the tax advantage of taking income from an immediate annuity. In short,income received from an immediate annuity is partially excluded (referred to as the Exclusion Ratio)from income taxes because a portion of the income payment is a return of principal. That portion of anannuity income payment is also excluded from the provisional income formula.For example, if an immediate annuity pays out $10,000 per year and 60% of the payout is a return ofprincipal; only $4,000 is included in the provisional formula. That alone can make the difference inkeeping the total provisional income below the 85% threshold. (More on Immediate Annuity income in Section V)SummaryFor high income earners, taxes can be the biggest impediment to growing and preserving wealth. Interms of preserving purchasing power, retirees who rely on a fixed income need every advantage Copyright 2012 - Annuity Think Tank – All Rights Reserved
  10. 10. available to minimize both income and Social Security taxes. Non-qualified deferred and immediateannuities are uniquely structured to maximize after-tax earnings during the accumulation phase andprovide essential tax relief during the income distribution phase. Finally, not even the die-hard bank CDadvocates’ debate the power that annuities have in regards to taxes. And if you don’t think that taxesare going to play an important role in the future with our ever growing debt, then think again.Reason #5 – CDs and Annuities as Retirement Income VehiclesImmediate annuities are gaining the attention of many Baby Boomers who, after having their IRAs and401k plans decimated by two market crashes (2001 and 2008) and a decade of stagnant stock returns,are fearful of the prospect that they could outlive their income.The basic annuity concept is fairly straightforward. Essentially, it is a contract arrangement in which anindividual exchanges a lump sum of money for guaranteed income payments over their lifetime or for aspecified period of time. The insurance company calculates the amount of income that can begenerated from the lump sum and guarantees a stream of payments consisting of a return of principaland interest. Immediate annuities also include an option (for an additional charge) to link incomepayments to inflation. For countless generations worldwide, annuities have remained one of the onlycontractually guaranteed lifetime retirement income vehicles around.By contrast CDs can be purchased with varying maturities to generate income based on prevailing fixedrates. Retirees who invest in CDs often create a “ladder” that is comprised of CDs with staggeredmaturities in order to stabilize the income. In period of rising interest rates, the ladder can generateincreasing income, and in periods of declining interest rates, the ladder will generate less income. Ineither case, there is no protection against inflation.One of the main arguments against an immediate annuity is that once you deposit your premium andincome payments begin, it is committed to the life insurer, whereas, with a CD, you can get your originalprincipal back once it matures. The argument ignores the fact that, annuity payments consist of bothinterest and principal, so the principle is being returned over time. It also disregards the use of joint lifeannuities that include an installment refund provision that pays any remaining principal to thebeneficiaries. Finally, there are many newer versions of annuities such as fixed indexed annuities andfixed annuities with living benefit lifetime income riders that accomplish the same goal with addedflexibility and control.CD – Annuity Income ComparisonA married couple has $200,000 to invest for income purposes. The husband is 65 and the wife is 64. Income Payout Rate Monthly Income 5-Year CD 1.6% Fixed Rate* $267 Copyright 2012 - Annuity Think Tank – All Rights Reserved
  11. 11. Immediate Annuity – 5.24% Annual Payout $874 Joint Life w/ Rate** Installment Refund * Highest available rate for 5-year CD as of October 2012, Source: Bankrate.com ** Source: immediateannuities.comWith the immediate annuity, the couple will receive $874 per month, guaranteed. At the first death, theincome will continue to the surviving spouse, and after the second death, their beneficiaries will receivethe remaining principle with interest in installments. An inflation rider will ensure that the income keepspace with the rate of inflation.With the CD, the income is only fixed until maturity, at which time it can increase or decrease dependingon the prevailing interest rates.But that’s only part of the story…The Annuity Income Tax AdvantageBecause only a portion of the annuity income consists of taxable income, that portion which is a returnof principal is not taxed. Therefore a percentage of the $874 monthly payment is not taxed. Todetermine the non-taxable portion, the IRS applies an exclusion ratio based on its life expectancy tables.In this example, joint life expectancy is 24 years. With a monthly payment of $874, the annuity’scontract value is calculated to be $249,646. Their exclusion ratio is 80% ($200,000/249,646). Therefore,80% of the $874 monthly payment, or $699, is excluded from taxes. CD-Annuity Income Comparison – After Taxes (25% tax bracket) Income Payout Rate Monthly Income 5-Year CD 1.6% Fixed Rate* $267 Immediate Annuity – 5.24% Annual Payout $830 Joint Life w/ Rate** Installment RefundIn addition, the income from the CD adds $2,844 to the provisional income calculation for Social Securitytaxes, while the immediate annuity income only adds $1,572 providing additional tax relief.SummaryMost people, and even some financial advisors, are not aware of the income tax implications ofretirement earnings on Social Security benefits. The notion that a benefit for which people have paidinto all of their lives could then be taxed as high as 85% should be bothersome to most people. With Copyright 2012 - Annuity Think Tank – All Rights Reserved
  12. 12. proper planning, and the use of deferred and immediate annuities it can be possible to at least avoid the85% threshold. At a time when retirees need to be able to maximize their income, they will need everyadvantage available to them.Reason #6 - CDs and Annuities as Financial Planning ToolsIn the previous sections CDs and Annuities are compared, in depth, for their ability to provide safety,minimize taxes and maximize retirement income – all key components of a well-conceived financialplan. In this section we examine them in the context of some additional financial planningconsiderations.Asset ProtectionUnder state and federal statutes assets such as pension plans, life insurance and annuities are protectedfrom civil liabilities, liens and debt claims. It is an accepted practice for individuals to arrange theirassets in a way that will shield them from claims so long as it is not done with intent to defraud. In somestates, assets held in annuities are fully protected against liability claims, but in others, their exemptionin limited to a specific dollar amount. In a few states, annuities are not exempt and, therefore, they arevulnerable to claims.LiquidityBoth CDs and annuities offer access to funds but with penalties attached prior to their maturity. CDsmust be held to maturity in order to receive the full amount of interest credited. Early withdrawals canresult in the loss of six months of interest. Annuity funds may be accessed anywhere from once tomultiple times annually, free of penalties as long as the amount doesn’t exceed 10% of the accountvalue during the surrender period. After the surrender period, any amount of your account value can bewithdrawn without penalty, however, withdrawals made prior to age 59 ½ are subject to both incometaxes and a 10% penalty tax.If you place $100,000 in a CD you can’t just access a part of it – the whole certificate would have to beredeemed. With an annuity you can withdraw $10,000 without penalty and without having to surrenderthe contract.Estate PlanningAbsent estate planning tools such as a living trust, non-qualified assets, such as CDs, are subject toprobate proceedings, which can be costly and result in the delay of asset transfer. As with life insuranceproceeds annuity proceeds pass outside of probate.The tax deferral aspect of deferred annuities also make them attractive options for funding certainestate planning components such as the A part of an A-B Trust and Charitable Remainder Trusts. Copyright 2012 - Annuity Think Tank – All Rights Reserved
  13. 13. SummaryCombined, these six well documented areas of comparison between an annuity and a CD, make it toughto argue the reasons to purchase a cd over an annuity. The most compelling reason that we hear to buya bank CD is the fact that it backed by the FDIC, which is a true statement. But considering that since2008 over 400 banks have declared bankruptcy (it has been a busy 4 years for the FDIC) and in that sametime frame not a single insurance carrier has declared bankruptcy (insolvency), that reason alone is notenough to convince us to buy bank CD’s over any annuity. Moreover, due to the reserve requirementsthat insurance companies are forced to follow, even the smallest insurance carriers have more reserves(proportionally) than any bank in the US.Finally, we hope you found this paper enlightening, educational, and thorough. The use of annuities toaddress any financial need should be considered only with the guidance of a qualified financialprofessional. Also, the use of annuities has tax implications which should be reviewed with your taxadvisor before ever making any financial decision.Disclaimer – This article in its entirety is purely educational and nothing in this article can be or shouldbe considered financial advice. It is imperative to speak to a Retirement Income Specialist before evermaking a decision to purchase an annuity or a cd. You are free to email this article, post this article in itsentirety to your website or blog, and any other form of distribution as long as there are NO changeswhatsoever to this PDF. To contact Annuity Think Tank about distributing or copying this article, pleaseemail them – info@annuitythinktank.com Copyright 2012 - Annuity Think Tank – All Rights Reserved

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